Evaluating a Trade Idea from an Institutional Research Firm

When it comes to stock market predictions, few are shy about playing the game.  After all, it doesn't cost anything to take a stab at the future – and if incorrect, the prognosticators simply ignore the prediction.  When correct, they milk it for all it's worth.

It's not only stocks, but prognosticators exist in all financial fields.  Options are no exception.  Many individuals and firms claim results ranging from reasonable to unbelievable.

It's difficult for anyone to know how to evaluate the claims of those making predictions, but it's not a good idea to blindly follow.

Recently, Adam (The Daily Options Report) reported on a trade suggestion made by a professional institutional equity trading and research firm.  It's a perfectly reasonable suggestion, and one that normally goes un-noticed, unless the trade idea appeals to you.

But I cannot let this one go without a comment.  I suppose the reason is to reinforce the notion that trade suggestions are merely that: suggestions.  No matter the source, the strategy suggested may be well thought out, or naive.  It may be well suited to you, or totally inappropriate.  It's always your responsibility, as the consumer, to carefully consider the suggestion before acting on it.

Here's an abbreviated excerpt of their recommendation (taken from Daily Option's Report):

"Given our view that PALM has a solid downside floor and number of catalysts that could drive shares sharply higher towards our $20 target price, we highlight May 2010 risk reversals
that  entail  selling  10  strike  puts  at  $1.70  to  buy  12 
strike  calls  for  $1.55  and  net  $0.15  credit.  Note  that  these 
prices  are  estimated,  based  on  the  pre‐market  trading  in  PALM 
at  $10.80.  This  position  commits  to  getting  long  stock  at 
the  equivalent  of  $9.85,  a  level  that  we  consider  to  be 
compelling  value, and provides levered participation to the
upside through the upcoming catalysts that we anticipate."


Here are my thoughts:

1) A 'risk reversal' involves buying one call and selling one put.

2) Selling the May 10 put and collecting $1.70 is very attractive for the bullish trader. 

a) If this idea turns out to be a loser, and if the trader is assigned an exercise notice, he/she owns PALM shares at $8.30.  That's a lot more attractive than paying $9.85 per share.

b) If the stock remains above $10 per share, the puts will eventually expire worthless.  The profit is $170 on an investment of $830 – and that's just over a 20% return on investment for a five-month trade.

3) Using the put proceeds of $170 to pay for the call options ($155 each) is a great way to own the call for no out of pocket cost.  The true 'cost' of the trade is taking the risk of owning shares at $9.85.

4) With the stock trading at $10.80 (at the time of the recommendation), that call option is out of the money by 11%, and it just feels wrong to pay that much premium for the this option.

5) Of course the recommendation suggests that PALM can rise to $20 per share.  If that happens, those calls will be worth at least $8 apiece.  A very nice profit of $815, or almost a 100% return on the same $830 (margin requirement) investment. 

6) Of course the stock can be any price when May expiration arrives.  But here's the dilemma as I see it.  If I want to make a bullish play on this stock (and I don't; this is merely a discussion of someone else's recommendation), is it good enough to sell the put and earn a 20% return if the stock remains above $10, and earn some profit if the stock remains above $8.30?

Or is it better to pay that $155 premium, buy the call, and hope that the people making this trade suggestion know what they are doing?  The potential gain is much larger, but the downside protection is only to $9.85 per share.

7) I choose selling the put with its much larger downside protection.  Others choose the risk reversal because the potential profit from buying the call is too large to resist.  But I don't like the odds of buying the call.  I prefer a higher probability of success, especially when the (5-month) 20% return is attractive.

556


NOTE:  Anyone relying on recommendations still has to take the time to consider the source, consider the strategy, evaluate the stock – and then decide if he/she wants to play or pass.  I pass on this one.

3 Responses to Evaluating a Trade Idea from an Institutional Research Firm

  1. Craig 12/21/2009 at 7:36 AM #

    Thanks for the opportunity to ask for clarification. Hopefully I can word the question I have so it is understandable.
    Let’s say I sell a covered call with a stock at $10 and strike price is $12. As I understand it, there isn’t anyway my stock would get called away if the stock price goes to $5.What you are saying is I am losing money because of the stock I bought. You are presuming it is now worth less if I sold it, and not that it will be called away.
    In other words, if the stock goes to $5, the buyer of my covered call could not buy it from me for $5. He would have to pay the strike price of $12 which he wouldn’t do, right?
    The falling stock price could hurt me only if it falls below my entry price. So if I own stock I bought at $2, and it goes to $10, then I sell a covered call with a strike price of $12, the stock retreats to $5. I have not lost money, have I?
    So one of two things will happen, right?
    1.My stock gets called away at the strike price plus I keep the premium.
    2.My stock does not get called away and I keep the premium.
    3. I have only lost money on a stock when I sell it and that depends of course on my entry point.
    Thanks!
    Regards,
    Craig

  2. Chartingstock 12/21/2009 at 8:46 AM #

    Excellent analysis & risk management, protecting the trades down side risk while allowing for great potential profits! Keep up the good work & have a great week/Holiday season.

  3. Mark Wolfinger 12/21/2009 at 9:06 AM #

    Craig,
    You brought up a topic that represents one of those things that occurs repeatedly. My opinion in that almost everyone get it’s wrong.
    I don’t understand the blind spot that makes people believe that have not lost money if they refuse to sell an asset.
    I hope you can wait until tomorrow when I’ll post a complete reply to your questions, along with my comments.